ACCA Financial Management (F9) Certification Practice Exam

Which of the following is the first source of funding according to the Pecking Order Theory?

1. Issue new equity

2. Convertible debt

3. Straight debt

4. Retained cash

The correct answer is: Retained cash

The Pecking Order Theory suggests that businesses prioritize their sources of financing based on the principle of least effort or least resistance, primarily influenced by the costs associated with issuing various types of financing options. According to this theory, firms first utilize retained earnings as their primary source of funding, which is also referred to as retained cash. Retained earnings represent profits that a company has reinvested in the business rather than distributed to shareholders as dividends. This is seen as the most cost-effective form of funding because it does not incur additional costs associated with issuing new debt or equity, such as interest payments or flotation costs. Furthermore, utilizing retained earnings avoids the potential dilution of existing shareholders' equity that occurs when new equity is issued. In contrast, other financing options, such as straight debt or convertible debt, follow retained earnings in the hierarchy. These options are generally considered to carry higher costs and risks; for example, they may require interest payments or have implications for future financial flexibility. As a result, according to the Pecking Order Theory, businesses will exhaust their internal funding sources, like retained cash, before seeking external financing options.